Definition of Accounting Rate of Return (ARR)
The Accounting Rate of Return (ARR) is a measure of the return expected from an investment based on the projected net income generated over its useful life. Specifically, ARR represents the ratio of average annual accounting profit to the initial cost of investment. It is expressed as a percentage and used primarily to assess the profitability and efficiency of investments. Unlike other financial metrics such as Net Present Value (NPV) or Internal Rate of Return (IRR), ARR relies on accounting profits rather than cash flows.
Formula:
\[ ARR = \left( \frac{\text{Average Annual Accounting Profit}}{\text{Initial Investment}} \right) \times 100 \]
Example:
Consider a company evaluating an investment of $200,000 in a new project. The project is expected to generate accounting profits of $25,000 per year for 8 years. The ARR calculation would be as follows:
- Total Accounting Profit over 8 years: \( $25,000 \times 8 = $200,000 \)
- Average Annual Accounting Profit: \( \frac{200,000}{8} = $25,000 \)
- ARR: \( \left( \frac{$25,000}{$200,000} \right) \times 100 = 12.5% \)
Examples
-
Industrial Equipment Purchase:
- Initial Investment: $500,000
- Estimated Annual Profit: $75,000
- Useful Life: 10 years
- ARR: \( \left( \frac{75,000}{500,000} \times 100 \right) = 15% \)
-
Retail Expansion Project:
- Initial Investment: $100,000
- Estimated Annual Profit: $10,000
- Useful Life: 5 years
- ARR: \( \left( \frac{10,000}{100,000} \times 100 \right) = 10% \)
Frequently Asked Questions (FAQs)
What are the key advantages of ARR?
- Simple to calculate and understand.
- Uses readily available accounting data.
- Helps in assessing the profitability of investments.
What are the limitations of ARR?
- Ignores the time value of money.
- Relies on accounting profits, which can be manipulated.
- Does not consider cash flows.
How is ARR different from IRR?
- ARR uses accounting profit, while IRR uses cash flows.
- ARR is simple but does not consider the time value of money; IRR includes time value consideration.
Can ARR be used for evaluating rental properties?
Yes, ARR can be applied to evaluate the profitability of rental properties based on expected rental income and investment costs.
What is a good ARR percentage?
A “good” ARR percentage is subjective and depends on the company’s required return threshold and industry standards. Generally, a higher ARR indicates a more profitable investment.
Related Terms with Definitions
Net Present Value (NPV)
The difference between the present value of cash inflows and outflows over a period of time. It considers the time value of money.
Internal Rate of Return (IRR)
The discount rate at which the net present value of all cash flows (both positive and negative) from a particular project or investment equal zero.
Payback Period
The time it takes for an investment to generate an amount of income or cash equivalent to the cost of the investment.
Return on Investment (ROI)
A performance measure used to evaluate the efficiency or profitability of an investment, calculated as the gain from an investment minus the cost, divided by the cost.
Cash Flow
The net amount of cash being transferred into and out of a business, especially in terms of operating, investing, and financing activities.
Online References
- Investopedia: Accounting Rate of Return
- Corporate Finance Institute (CFI): ARR
- LinkedIn Learning: Accounting Rate of Return
Suggested Books for Further Studies
- “Financial Statement Analysis and Security Valuation” by Stephen Penman
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
- “Accounting: Tools for Business Decision Makers” by Paul D. Kimmel, Jerry J. Weygandt, and Donald E. Kieso
Accounting Basics: “Accounting Rate of Return (ARR)” Fundamentals Quiz
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